Apple’s stock price: Bottom of the class or ahead of its time?

[Ed. Note: All specific data references are as of Apple’s 4Q FY2000 announcement, with market data as
at close of trading 20 October. As at close of trading 21 November,
Apple’s P/E ratio was 8.7.]

Apple’s in the doghouse as far as Wall Street is concerned. Out of
the entire S&P 500 index, Apple
has the 144th-worst price-earnings ratio (P/E), the 32nd-worst year-ended
price change, and the 14th-worst price change from its 52-week high.
Adjusted for market capitalisation, it’s in the bottom
10 percent on P/E and bottom 5 percent on the two price measures.

Now maybe this makes sense. The stock market has been completely overblown
for years, particular for tech stocks. As the editor of this Web site
recently pointed out, sometimes
it seems that shares were treated as assets in themselves, instead of
simply representing part ownership of a company. But a share is nothing
more than the right to a portion of the residual cashflow of a company.
After the workers have got their wages and the suppliers their fees, after
the creditors have all been paid and the government taken its tax
remittances, what’s left over belongs to the shareholders. How you
value that share depends on what you think will happen to net profits in
the future. That’s a hard calculation. But it is the calculation you
should do. Not hit rates, not churn, and not number of customers.
Profits.

In recent years, people forgot this fundamental fact. In the new economy,
they said, you could throw out the old rulebook, because the computer nerds
have invented new ones. So naïve day traders and dupes looking to get
rich quick hopped onto their investor message boards and into tech stocks
trading at sky-high earnings multiples. In the short run, some of them
even made money. They bought shares in the belief they would rise in price
later. Enough people believed this, and bought shares. The increased demand
raised the price as they expected, so they made a profit, but then they had
to get out again to realise the profit. They had to flick-pass the share to
some other dupe. In the industry, this is known as the “Greater Fool
Theory” – that is, that there will always be a greater fool
than you on whom you can unload your overvalued stock. This may be true
for you, but it can’t be true for everyone. At some stage, things
are going to come unstuck; that’s what we are seeing now.

But if the market has to come down to restore sensible valuations, and
price-earnings ratios have to fall, is 11 and a bit the right ratio for
Apple?

Future profits are what matters in determining fundamental share prices. To
work out that price, you need the present discounted value formula out of
the Corporate Finance 101 textbook. It’s really an integral of the
exponential function, but for a constant discount factor and a constant
rate of profits growth, it comes out as the very neat and tidy formula:

1/(r – g)

where r is the discount rate and g is the growth rate for
profits. For example, if profits grew by 2 percent a year, and the
discount rate was 5 percent a year, then the appropriate price for
shares in that company would be just over 33 times current earnings. In
the long run, total profits growth should be the same as growth in the
economy. Otherwise, the corporate sector would either get bigger than the
whole economy, which is impossible, or shrink to nothingness, which is
nuts. A rough figure for US trend economic growth, excluding inflation, is
about 2.5 percent, so let’s say 4.5 percent including
inflation for long-run average growth in profits. (Strictly speaking, this
should all be in terms of dividends, but most analysts use earnings
instead, on the grounds that all earnings come back to the shareholders
eventually as dividends or through a buyback, even if only after a long
time.)

Apple and the S&P 500
As of 20 October 2000

Apple

Median

Weighted Mean

Price-earnings ratio

11.21

29.16

52.63

Year-ended price change (%)

-49.6

17.73

38.12

Price change from 52-week high (%)

-74.8

-17.95

-23.29

Of course, these calculations depend on the number you pick for your
discount rate. Most people start with a government bond rate, then add a
bit for risk, because private companies are more risky creditors than the
government. The size of that risk adjustment is a matter of passionate
debate, but let’s be optimistic and only add a few percentage points,
which brings us to 8 or 9 percent. (You could adjust for inflation,
but you would also have to adjust your expected profits growth number
(g). The adjustments would cancel and you would get the same P/E.)
But with a discount rate of 9 percent, a P/E of 11.2 implies profits
will be essentially unchanged in dollar terms, forever. If your discount
rate was lower, like most “new economy” boosters think applies
now, then a P/E around 11 implies profits that fall forever.

There are other ways you can get a P/E around 11.2: assume profits are
going to fall sharply for a while and grow after that, or assume that the
company is going to fold after a few years, so you are only adding up
profits over a finite period. But to make the numbers add up, you need to
make some extreme assumptions about the initial falls. For example, with
g=4.5% and r=9%, one way to get a P/E of around 11.2 is
assume profits fall 13 percent a year for six years in a row, before
reverting to g=4.5%, and then the company folds after 20 years.

That’s nowhere near the profit outlook that analysts have been
suggesting, which is two quarters of softness, not twenty-four. The median
price-earnings ratio is currently around 29.2 – that is, half of the
market capitalisation in the S&P 500 is in companies with a P/E higher
than that figure. Assuming the underlying riskiness of stocks is the same
for all companies, they all face the same discount rate and long-run rate
of economic growth. So either the market is massively overvalued, or Apple
is undervalued. If 11.2 is the right P/E for Apple, then as a simple
matter of arithmetic, the rest of the market must be massively overblown
and heading for a correction of its own.

That, or the company is heading for an imminent demise.

Maybe that’s what some of the traders who dumped Apple in October
really believe. Or maybe Apple is just correcting from the general
market’s overvaluation and the rest of the market will correct in the
near future. But right now, Apple looks undervalued relative to history,
undervalued relative to the rest of the current market, and undervalued
relative to its industry peers. In the current environment, that’s
no guarantee it will recover. But it makes clear that Apple has been
punished for its recent soft profitability, and punished by more than some
others in a similar situation.

Robert Barton (not his real name) is an economist at a financial
institution with an international presence. His opinions are not those of
his employer. Neither Mr Barton nor his employer trades in Apple shares.
This article should not be construed as financial advice.